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SPECIAL REPORT: INDEX MANAGERS

Managers still see magic with ETFs, wading into the market despite crowds

Jonathan Thomas feels confident that American Century can stake a claim in the burgeoning ETF marketplace.

Firms continue wading into the market for exchange-traded products despite crowds

Updated with correction.

As inflows into ETFs smash records and passive and smart-beta strategies gain assets at the expense of active management, more money managers are seeking a slice of the exchange-traded fund pie.

The latest money manager to express interest in ETFs is AQR Capital Management LLC, which in August said it had asked the Securities and Exchange Commission for exemptive relief to offer exchange-traded products. AQR, which has $195 billion under management, offered no timetable for its plans.

Newcomers undoubtedly are enticed by the growth in ETFs. According to Pensions & ​ Investments' 2017 ranking of the largest index managers, assets in exchange-traded funds and notes under internal management globally surged 35.6% to $3.18 trillion.

And data from Morningstar Direct show 2017 net inflows of $298.1 billion as of Sept. 12 for the U.S. ETF market, exceeding the record $286.5 billion for all of 2016.

The spoils so far have mostly gone to an early group of ETF adopters such as BlackRock (BLK) Inc. (BLK), which gained entry in 2009 with its purchase of Barclays Global Investors and its iShares ETF business, and Vanguard Group Inc., which began building an ETF business in 2001 on top of its successful index business.

BlackRock continues to build scale in the ETF and passive investment business taking the top spot in the P&I ranking with $3.68 trillion in internally managed indexed assets. Of that, it held $1.53 trillion in ETF assets under management.

More than $200 billion

Net ETF inflows at BlackRock (BLK) could exceed $200 billion in 2017 if current trends continue, said equity analyst Robert Lee, a managing director at Keefe, Bruyette & Woods Inc. in New York.

"When they considered acquiring BGI, they had the foresight to say 'this is a once-in-a-lifetime opportunity to buy a franchise like this' and they grabbed it," he said.

At. AQR, company officials said no formal decision has been made to offer ETFs even though the firm filed for exemptive relief.

"What we do is still to be determined," said David Kabiller, co-founder and head of business development. "We will only move ahead if we think our clients are better served."

"There are some structural benefits to ETFs due to tax efficiency," he said. "AQR wants to be structure-agnostic. The key thing is for us to build the best investment processes that we can and have the best structure available that allows the client to achieve the best net results. If there is less frictional cost, be it taxes or fees, that allow our client to get the better result, we need to have that as an option in our arsenal."

Other money managers have been more definite in their plans. American Century Investments, Kansas City, Mo., plans to offer smart-beta ETFs in early 2018 and could also add active ETFs, said CEO Jonathan Thomas. To lead the effort, American Century in June hired Edward Rosenberg, a former top executive at FlexShares, the ETF business of Northern Trust Asset Management.

For active managers, so-called smart-beta ETFs, which use rules-based investment factors to enhance passive returns, have been a key entry point into the ETF game. Money managers such as Hartford Funds, Columbia Threadneedle Investments and OppenheimerFunds all acquired small ETF firms to jump-start their way into the ETF business and smart beta over the last few years.

Other firms have used a hybrid approach. Legg Mason (LM) Inc. (LM), for example, recruited two top ETF executives from Vanguard in 2015 for its new ETF effort. But in 2014 it also purchased money management firm QS Investors LLC, known for its factor-based quantitative investment process.

QS became the first of Legg Mason's investment affiliates to launch ETF strategies in 2015. It since has been followed by other Legg Mason affiliates, though none of the firms have yet to gather significant assets under management.

Legg Mason has more than $740 billion in assets under management but its ETF franchise made up just $553.3 million as of Sept. 12, even with net inflows of $397.3 million during that period, Morningstar data show.

Hartford Funds added $159.8 million in inflows for the year so far through Sept 12, but its ETF assets totaled just $259.1 million, according to Morningstar.

Other firms, such as money manager Franklin Resources Inc., have been building a smart beta and active ETF platform from scratch. Franklin started offering one ETF in 2013 but last year expanded that to a suite of ETFs under the direction of Patrick O’Connor, a former top BlackRock ETF official who joined Franklin in 2015.

At $788.9 million, Franklin's ETF assets are still just a fraction of the company's $742 billion in total AUM.

New ETF businesses still need to figure a way to gather significant assets to make long-term profits, said Craig Siegenthaler, an equity analyst and managing director at Credit Suisse in New York.

Mr Siegenthaler said ETFs launched by money managers that were late to the market don't have much in assets and will need to develop at least a three-year track record to attract substantial ETF inflows.

"The verdict is still out," he said as to whether the firms can develop a successful ETF business.

The Morningstar Direct data show much of the ETF inflows in 2017 can be attributable to just BlackRock and Vanguard. BlackRock had $140.9 billion in U.S. ETF inflows in 2017 through Sept. 12, compared to $105 billion in 2016, while Vanguard's $94.5 billion in net inflows as of Sept. 12 already exceeds its $94.3 billion for all of 2016.

Seeing a niche

The experience of competitors is not stopping executives such as American Century's Mr. Thomas from trying to make a go of the ETF business. Like other managers, the CEO said he is avoiding direct competition with the largest ETF providers — BlackRock (BLK), Vanguard and No. 3-ranked State Street Global Advisors — and their domination of index-based ETF strategies.

"Three companies control 80% of the market," Mr. Thomas said in an interview. "On the passive side, there's three guys in the room eating everybody's lunch. So we're not even contemplating going into the passive space. Many years ago we determined that would be a race to the bottom on fees and we just aren't positioned correctly to win that race."

He does believe American Century can succeed with its own smart-beta, factor-based ETFs and said the company also is looking at potential active ETFs.

First out of the gate will be some smart-beta strategies in early 2018, Mr. Thomas said.

American Century is looking to develop "some factors that have not been exploited before by other providers," he said.

"We have a team called global analytics — it's a team of some Ph.D.s out in Mountain View (Calif.),'' he said. "They are investment management engineers ... they are working on interesting concepts for us right now on the factor-based products."

Mr. Thomas would not offer specifics but said the team, created to help American Century develop overall investment strategies, would be developing five to seven factor-based ETFs.

But leader BlackRock is not sitting still. It offers its own set of smart-beta or factor-based ETFs, which the company says amount to about 6% of its global ETF assets under management.

"Many of them (ETF smart-beta competitors) don't have the heritage in the factor world like BlackRock and a few others do in the space," said Robert Nestor, New York-based managing director and head of iShares smart beta and fixed-income product strategy. "It takes a while to get to scale, to really have a chance to make the economics work; we'll see what happens."

Not competing

New York-based Amanda Walters, a senior manager at consulting firm Casey Quirk, a practice of Deloitte Consulting LLP, said money managers that attempt to build a passive presence through smart-beta ETF strategies aren't attempting to take on the largest managers.

"Their expectations are not ever to be the next BlackRock (BLK) or Vanguard. ... It's more to have an offering to hopefully keep some assets in the door," she said.

She said a Casey Quirk study in 2016 of about 100 money managers found that managers with a large number of passive or smart-beta strategies saw average AUM growth of 6% vs. a 1% decline for managers focused on active strategies. But there was a catch: active managers saw a 3% compression in their fees in 2016 compared to 5% for passive managers.

Passive management fees are compressing at a much faster rate because of competition; some firms have cut fees for strategies to as little as 2 or 3 basis points, Ms. Walters said. That's creating a "race to the bottom at this point as managers approach the zero-basis-point mark."

Pressure on fees will continue, particularly for ETF providers, said Todd Rosenbluth, director of ETF and mutual fund research at CFRA, an independent investment research firm in New York.

"I think that fees have been coming down and are likely to continue to come down," he said. "Investors have been embracing lower-cost products this year in particular.

"There's two ways to gain assets in the ETF marketplace. One is to be relatively unique and to offer something that no one else has. Or you can offer a cheaper version of what people have already adopted and try to take share.

"I think that in terms of gathering assets, launching a cheaper version of something that has already been popular is more likely to gather assets. The question is, if you charge 9 basis points for it, how much money are you making?''

Mr. Rosenbluth said that puts the odds of survival in favor of ETF firms part of larger money management organizations because they have a greater ability to support losses while building assets.

But rating agency Moody's Investors Services, in a Sept. 14 report, noted that a decision in September by Goldman Sachs Asset Management to price a new smart-beta ETF at 9 basis points could trigger a price war and result in a lower credit ratings for managers new to offering the ETFs, such as Legg Mason (LM), Franklin Resources and Janus Henderson Investors. Also at risk for a potential credit downgrade were more established players the report said: BlackRock, State Street, Invesco (IVZ) Ltd. and WisdomTree Investments Inc.

"GSAM is now the first major market participant — outside of mutually owned company Vanguard — that is signaling pricing for smart-beta products below 10 basis points, a level traditionally associated with plain-vanilla index products," the report said.

"The plain-vanilla ETF category has experienced a severe price war in which product pricing has migrated towards zero basis points, and this aggressive pricing competition is migrating up towards the smart beta category," the report said.

The report noted that up to now, most smart-beta ETFs had been priced between 24 and 39 basis points, around half the fees of traditional active equity mutual funds, but still above straight index ETFs, and a price point at which money managers felt they could grew assets under management without "putting too much sacrifice on revenue."

Price competition on smart-beta products still has not eroded the luster of owning such a ETF franchise.

Chad Astmann, the New York-based head of executive recruiter Heidrick & Struggles' North American asset management practice, said smaller firms that have the ability to deliver new ETF or smart beta strategies are in play.

Eyed for acquisitions

He said that firms with $2 billion or less under management are being eyed for acquisitions or key personnel liftouts by larger money managers with distribution capabilities.

He said the current market makes it difficult for smaller firms to survive without a bigger partner.

"It is nearly impossible to get scale even if you have a very innovative product; the math on these very low-cost products is such that you have to have scale to succeed," he said. "You can't run it like you would a small hedge fund, where the economics are very enticing. The economics on a smart beta product tend to be very, very low, so you have to have scale to succeed and frankly just to exist, and to advance and be competitive and prosper."

The need for scale is driving what is expected to be more consolidation in the ETF industry. Equity analysts are following the April announcement that money manager Invesco (IVZ) is acquiring European ETF provider Source, with $18 billion in ETF assets and another $7 billion in subadvised assets.

Even before the transaction, Invesco was the fourth-largest global ETF provider. It had $128.25 billion in ETF assets as of June 30, P&I data show.

Mr. Siegenthaler said Invesco is a big believer that the ETF business worldwide will grow larger. And late last week, Invesco announced it would be growing again through a new acquisition.

On Sept. 28, the money manager announced it is officially purchasing the $36.7 billion ETF business of Guggenheim Investments for $1.2 billion.​